Electronic netting system for bilateral trades

ABSTRACT

An electronic netting system. The system may include: (a) a plurality of individual, segregated counterparties for providing bilateral trades, (b) a multi-lateral transaction hub, and (c) a trading system in communication with the transaction hub. The multi-lateral transaction hub may be for (i) providing an aggregation of trades between the counterparties, (ii) providing for multi-lateral netting of selected and authorized bilateral trades, and (iii) apportioning the accumulated trade values among the counterparties according to pre-determined netting parameters including a weighted distribution selectable by at least one of the counterparties. The transaction hub may include: (i) a trade processing system and (ii) a netting system in communication with the trade processing system for providing for the optimized, multi-lateral netting of selected and authorized bilateral trades and apportioning the accumulated trade values among the counterparties.

RELATED APPLICATIONS

This application is a divisional of U.S. application Ser. No. 11/319,002filed Dec. 27, 2005, which is incorporated herein by reference in itsentirety.

BACKGROUND OF THE INVENTION

1. Field of the Invention

The present invention relates generally to electronic trading systemsand, more particularly, to a system for multi-lateral netting ofbilateral trades of OTC derivatives.

2. Description of the Prior Art

Financial derivatives are contracts of which the price/value of thecontract varies with the value of an underlying instrument. Financialderivatives can either be standardized contracts traded on a recognizedExchange or OTC traded. OTC derivatives are individually negotiated andtailor-made between two counterparties (so called “over the counter(OTC) transactions”). The parties do their own valuation of thecontracts both when dealing as well as later on when establishing themarket value of their contracts during their life.

Participants in the OTC markets are banks, investment banks and otherfinancial institutions. The International Swap and DerivativesAssociation is a trade organization for dealers active in the OTCderivatives market. An OTC derivative transaction allows the financialinstitution to manage its market risk positions, either for the purposeof hedging or for the purpose of deliberate position taking to make aprofit from an expected change in market prices. Derivatives allow themarket risk of substantial amounts to change hands without the need andassociated costs of transferring the underlying values.

A thorough discussion of other aspects of OTC derivatives may be foundin U.S. Published Patent Application 2003-0083978 entitled “System andmethod of implementing massive early terminations of long term financialcontracts” by Brouwer which is hereby incorporated by reference in itsentirely.

However, because of the volume of trade, it is often possible that thecounterparties involved have off-setting trades which, if “ripped up”prior to the confirmation process, can result in reduction of costs tothe counterparties such as reduction in economic and regulatory capitalusage; and reduction in counterparty risk exposure. As can beappreciated, offsetting bi-lateral trades between just twocounterparties is a simple process. However, offsetting or nettingtrades between a plurality of individual, segregated counterparties toprovide for multi-lateral netting is more complex.

Thus, there remains a need for a new and improved electronic nettingsystem which provides netting of bilateral trades while, at the sametime, is operable to provide optimized, multi-lateral netting among aplurality of individual, segregated counterparties.

SUMMARY OF THE INVENTION

The present invention is directed to an electronic netting system. Thesystem may include: (a) a plurality of individual, segregatedcounterparties for providing bilateral trades, (b) a multi-lateraltransaction hub, and (c) a trading system in communication with thetransaction hub. The multi-lateral transaction hub may be for (i)providing an aggregation of trades between the counterparties, (ii)providing for multi-lateral netting of selected and authorized bilateraltrades, (iii) apportioning the accumulated trade values among thecounterparties according to pre-determined netting parameters includinga weighted distribution selectable by at least one of thecounterparties; and (iv) including the selection of a preferredcounterparty credit exposure.

In a preferred embodiment, the individual, segregated counterparties arefinancial institutions. The financial institutions may be banks. Thebanks may include investment banks.

Also in a preferred embodiment, the bilateral trades are OTCderivatives. The OTC derivatives may be credit derivatives. The creditderivatives may be credit indices.

Preferably, the transaction hub may include: (i) a trade processingsystem (ii) a netting system in communication with the trade processingsystem for providing for the optimized, multi-lateral netting ofselected and authorized bilateral trades and apportioning theaccumulated trade values among the counterparties; and (iii) a tradeconfirmation matching service.

The trade processing system may include an input of the bilateral tradesand a database for storing the input and an output of the trades. Theinput may include the parties, the instrument, the price, the size, andthe upfront fee. The input may further include additional trade details.The input may also include data from E-trading. The trade processingsystem may further include external trade input. In a preferredembodiment, the output may include trade confirmations.

In an embodiment, the trade processing system may further include atrade verification module. The trade verification module may bebilaterally verified.

Preferably, the netting system may include an input of trades (T₁, T₂, .. . T_(N)), a recursive application of the optimization algorithm of theoptimization engine, and an output of netted trades. The recursiveoptimization engine may further include a first netting interval. Therecursive optimization engine may also include at least one subsequentnetting interval for netting the remainder of unnetted and netted tradesfrom the preceding netting interval. In an embodiment, the nettingsystem may further include an input of additional netting parameters.The additional netting parameters may include at least one counterpartytrading limit.

In one embodiment, the output of netted trades may further include apayment output. The payments may be netted. The payments may also becollected by a central party.

The output of netted trades may also include a reconciliation output.Preferably, the additional netting parameters may include nettingconstraints. The netting constraints may be selected from the groupconsisting of limits of trades; limits of notional and combinationsthereof. The additional netting parameters may include nettingobjectives. In an embodiment, the netting objectives may be selectedfrom the group consisting of total gross notionals; number of trades;variance of the notional; distribution of netted trades by counterparty(i.e. the counterparty credit exposure distribution); and combinationsthereof.

In a preferred embodiment, the netting system may also include an inputof additional algorithm parameters. The additional algorithm parametersmay include a notional change selector or a party search order.

Preferably, the trading system may be an intermediary party such as anE-trading system. The intermediary party may include at least one voicebroker. Alternatively, the intermediary party may include at least onevoice broker and an E-trading system.

Accordingly, one aspect of the present invention is to provide anelectronic netting system. The system may include: (a) a plurality ofindividual, segregated counterparties for providing bilateral trades;(b) a centralized, multi-lateral transaction hub; and (c) a plurality ofcounterparty intermediaries for credit risk purposes. The centralized,multi-lateral transaction hub may be for: (i) providing an aggregationof trades between the counterparties; (ii) providing for multi-lateralnetting of selected and authorized bilateral trades; and (iii)apportioning the accumulated trade values among the counterpartiesaccording to pre-determined netting parameters including a weighteddistribution.

Another aspect of the present invention is to provide a multi-lateraltransaction hub for providing an aggregation of trades between aplurality of individual, segregated counterparties and providing for themulti-lateral netting of selected and authorized bilateral trades. Thetransaction hub may include: (a) a trade processing system; and (b) anetting system in communication with the trade processing system forproviding the optimized, multi-lateral netting of selected andauthorized bilateral trades and apportioning the accumulated tradevalues among the counterparties according to pre-determined nettingparameters including a weighted distribution selectable by at least oneof the counterparties.

Still another aspect of the present invention is to provide anelectronic netting system. The system may include: (a) a plurality ofindividual, segregated counterparties for providing bilateral trades;(b) a multi-lateral transaction hub for: (i) providing an aggregation oftrades between the counterparties; (ii) providing for multi-lateralnetting of selected and authorized bilateral trades; and (iii)apportioning the accumulated trade values among the countetpartiesaccording to pre-determined netting parameters including a weighteddistribution selectable by at least one of the counterparties, thetransaction hub including: (i) a trade processing system; and (ii) anetting system in communication with the trade processing system forproviding for the optimized, multi-lateral netting of selected andauthorized bilateral trades and apportioning the accumulated tradevalues among the counterparties; and (c) a trading system incommunication with the transaction hub.

These and other aspects of the present invention will become apparent tothose skilled in the art after a reading of the following description ofthe preferred embodiment when considered with the drawings.

BRIEF DESCRIPTION OF THE DRAWINGS

FIG. 1 is an overall block diagram of an electronic netting systemconstructed according to the present invention;

FIG. 2 is a schematic representation of the transaction hub shown inFIG. 1;

FIG. 3 is a flow chart of the main algorithm loop of the optimizationengine shown in FIG. 2;

FIG. 4 is a flow chart of the optimization engine shown in FIG. 2 inrecursive mode;

FIG. 5 is a flow chart of the optimization engine shown in FIG. 2 withintervals and/or remainder netting;

FIG. 6 is a flow chart of the operation of the electronic netting systemshown in FIG. 1;

FIG. 7 is a screen shot of the raw data of original trades prior tomulti-lateral netting of the selected and authorized bilateral trades;

FIG. 8 is a screen shot of the output from the transaction hub followingaggregation and multi-lateral netting of the selected and authorizedbilateral trades; and

FIG. 9 is a flow chart of the operation of the electronic nettingsystem.

DESCRIPTION OF THE PREFERRED EMBODIMENTS

In the following description, like reference characters designate likeor corresponding parts throughout the several views. Also in thefollowing description, it is to be understood that such terms as“forward,” “rearward,” “left,” “right,” “upwardly,” “downwardly,” andthe like are words of convenience and are not to be construed aslimiting terms.

Referring now to the drawings in general and FIG. 1 in particular, itwill be understood that the illustrations are for the purpose ofdescribing a preferred embodiment of the invention and are not intendedto limit the invention thereto. As best seen in FIG. 1, an electronicnetting system, generally designated 10, is shown constructed accordingto the present invention. The electronic netting system 10 includesthree components: a plurality of individual, segregated counterpartiesfor providing bilateral trades 12; a multi-lateral transaction hub 14for providing an aggregation of trades between the counterparties andproviding for multi-lateral netting of selected and authorized bilateraltrades; and a trading system 16 in communication with the transactionhub.

Preferably, the individual, segregated counterparties are financialinstitutions, such as banks or investment banks. Also, in the preferredembodiment the bilateral trades for OTC derivatives such as creditderivatives and most preferably credit derivatives, which are creditindices. However, other OTC derivatives assets could also be traded andnetted by the present invention.

The electronic netting system 10 also includes a centralized,multi-lateral transaction hub 14 for providing an aggregation of tradesbetween the counterparties, for providing for multi-lateral netting ofselected and authorized bilateral trades, and for achieving desiredcounterparty credit risk profiles for each party. The arrangement inoperation of the multi-lateral transaction hub will be discussed in moredetail subsequently.

The present invention may further include a trading system 16 incommunication with the transaction hub 14. In a preferred embodiment,the trading system is an intermediary party. The intermediary party mayinclude at least one broker or an E-trading system or may include acombination of voice brokers and an E-trading system. In addition,external trades 30 may also be in communication with the multi-lateraltransaction hub 14.

Turning now to FIG. 2, there is shown a schematic representation of thetransaction hub 14 shown in FIG. 1. In the preferred embodiment, themulti-lateral transaction hub 14 includes a trade processing system 20and a netting system 22 in communication with the trade processingsystem 20 for providing for the optimized, multi-lateral netting ofselected and authorized bilateral trades. The trade processing system 20includes an input 24 of the bilateral trades, a database 26 for storingthe input 24, and an output 25 of the completed trades. In the preferredembodiment, the input 24 includes identification of the parties, theinstrument, the price, the size, and the fee. The input 24 may furtherinclude additional trade details such as trade date, effective date,asset rank, documentation, maturity date, currency, referenceobligation, day count method, date convention, payment period, andcalendar region. The input 24 may also include data from E-trading ormay further include external trade input. The output 25 of the tradeprocessing system 20 may also include trade confirmations.

In the preferred embodiment, the transaction hub 14 further includes atrade verification module 32, which preferably provides for bilateralverification of the trade by both parties.

Turning to FIG. 3, there is shown a flow chart of the main algorithmloop of the optimization engine of the transaction hub shown in FIG. 2.In the preferred embodiment, the optimization engine receives aplurality of inputs of trades and provides an output netted trades afteroptimization. A flow chart of the optimization shown in FIG. 2 is bestseen in FIG. 4. The application of the algorithm is recursive.

As seen in FIG. 5, the recursive optimization engine is typically runusing a first netting interval, such as the end of the day. However, inthe most preferred embodiment, the recursive optimization engine mayfurther include at least one subsequent netting interval for netting theremainder of unnetted trades from the preceding netting interval. As canbe appreciated, these netting intervals may be weekly or monthly,depending on the assets being traded.

The netting system 22 may further include an input of additional nettingparameters 52, such as having at least one counterparty trading limit.In addition, the output of netted trades 40 may further include apayment output 46. The payment output 46 may be netted or they may becollected by a central party. Finally, the netting system 22 may alsofurther include a reconciliation output 50 of the output of nettedtrades 40.

Turning to FIG. 6, there is shown a flow chart of the operation of theelectronic netting system 10 shown in FIG. 1. In operation, the brokersfirst trade between counterparties, such as counterparty A andcounterparty B, by voice trading or by E-rrading or a trade is importedfrom an external system. Trade data is then entered into the centralizedmulti-lateral hub 14. The counterparties may view their trade and bothcounterparties may verify 32 and allow the trade for netting before theend of the pre-selected trading interval. The netting system 22 runs therecursive optimization engine and provides the optimized multi-lateralnetting of the selected and authorized bilateral trades and outputsthese trades 40. The output netted trades 40 are sent to each of thecounterparties are then downloaded from the electronic netting system 22into each counterparty's trading system.

A screen shot of the raw data of the original trades prior tomulti-lateral netting of the selected and authorized bilateral trades isshown in FIG. 7. Counterparties may verify 32 and authorize trades fornetting. A screen shot of the output from the transaction hub 14following aggregation and multi-lateral netting of the selected andauthorized bilateral trades is shown in FIG. 8. Counterparties may viewthe output of netted trades 40, payments 46, and view a reconciliation50.

FIG. 9 shows both the daily and recursive application of theoptimization algorithm. The netting system 22 of the present inventionwhich can be used for apportioning the accumulated trade values amongthe counterparties according to predetermined netting parametersincluding a weighted distribution. The netting system 22 also allows forthe generation of a diversified portfolio of counterparty credit risk.The netting system may include an input of trades, a recursiveoptimization engine, and an output of netted trades. The netting systemmay also include an input of additional netting parameters such as atleast one counterparty trading limit. The additional netting parametersmay include netting constraints. Multiple netting constraints 48 areallowed. Possible netting constraints include: limiting the total grossnotional of each party, limiting the number of trades for each party,limiting the size of any one notional, and combinations thereof. Theadditional netting parameters may also include netting objectives.Possible netting objectives 50 include: total gross notionals, number oftrades, variance of the notionals, counterparty credit risk profiles,and combinations thereof. The netting system may include an input ofadditional algorithm parameters. The algorithm parameters may include anotional change selector 52 or a party search order 54.

In one embodiment, the new process is performed as follows: theoptimization process is run as described above, and then at the end ofsome period of time, such as one week, the system takes the last 7 daysworth of optimized trades and combines the trades using bilateralnetting. Next, the system runs the optimization algorithm usingmulti-direction search as described above and best seen in FIG. 3, withthe following changes: the choice of value to change the notionals ofthe 3 trades at each step is now given by d=(n1−n2+n3)/3, where thisvalue is rounded to the closest million. However, another value may beused. Additionally, the objective function is taken as the variance ofthe notionals (taking account of the direction e.g. we allow forpositive and negative notionals) in the positions. At the end of therecursive optimization procedure, the resulting optimized trades replacewhatever trades the bank performed with each counterparty, as is thecase for the daily optimization.

This recursive process in combination with the choice of d, whered=(n1−n2+n3)/3 and the different objective function has the desiredeffect of minimizing the variance of each party's optimized positionwith each counterparty. For example, this process allows for theavoidance of undesirable concentrations of exposure to a particularcounterparty. This technique results in few trades (one per distinct setof counterparties with large notionals).

Certain modifications and improvements will occur to those skilled inthe art upon a reading of the foregoing description. By way of example,while a recursive algorithm is a preferred embodiment of the presentinvention, different algorithms may be used to provide for optimization.For example, a “differential evolution” algorithm or a “simulatedannealing” algorithm. Also, the steps of trade verification andexplicitly allowing trades for netting could potentially be omitted forsome applications. Furthermore, while the transaction is centralized ina preferred embodiment of the invention, it may be decentralized. Also,while netting is preferably performed on identical instruments, nettingcould also be performed on similar but not identical instruments.Finally, additional netting parameters may include an indication of acounterparty's preference for reduction in number of trades versus areduction in gross notional. It should be understood that all suchmodifications and improvements have been deleted herein for the sake ofconciseness and readability but are properly within the scope of thefollowing claims.

1. A multi-lateral transaction hub for providing an aggregation oftrades between a plurality of individual, segregated counterparties andproviding for the multi-lateral netting of selected and authorizedbilateral trades, the transaction hub comprising: (a) a trade processingsystem; and (b) a netting system in communication with the tradeprocessing system for providing for the optimized, multi-lateral nettingof selected and authorized bilateral trades and apportioning theaccumulated trade values among the counterparties according topre-determined netting parameters including a weighted distributionselectable by at least one of the counterparties.
 2. The transaction hubaccording to claim 1, wherein the trade processing system includes aninput of the bilateral trades, a database for storing the input and anoutput of the completed trades.
 3. The transaction hub according toclaim 2, wherein the input includes the parties, the instrument, theprice, the size, and the upfront fee.
 4. The transaction hub accordingto claim 3, wherein the input further includes additional trade details.5. The transaction hub according to claim 2, wherein the input includesdata from E-trading.
 6. The transaction hub according to claim 2,further including external trade input.
 7. The transaction hub accordingto claim 2, wherein the output includes trade confirmations.
 8. Thetransaction hub according to claim 2, further including a tradeverification module.
 9. The transaction hub according to claim 8,wherein the trade verification module is bilaterally verified.
 10. Thetransaction hub according to claim 1, wherein the netting systemincludes an input of trades (T₁, T₂, . . . T_(N)), a recursiveoptimization engine, and an output of netted trades.
 11. The transactionhub according to claim 10, wherein the recursive optimization enginefurther includes a first netting interval.
 12. The transaction hubaccording to claim 11, wherein the recursive optimization engine furtherincludes at least one subsequent netting interval for netting theremainder of unnetted trades from the preceding netting interval. 13.The transaction hub according to claim 10, further including an input ofadditional netting parameters.
 14. The transaction hub according toclaim 13, wherein the additional netting parameters include at least onecounterparty trading limit.
 15. The transaction hub according to claim10, wherein the output of netted trades further includes a paymentoutput.
 16. The transaction hub according to claim 5, wherein thepayments are netted.
 17. The transaction hub according to claim 15,wherein the payments are collected by a central party.
 18. Thetransaction hub according to claim 10, wherein the output of nettedtrades further includes a reconciliation output.
 19. The transaction hubaccording to claim 13, wherein the additional netting parameters includenetting constraints.
 20. The transaction hub according to claim 19,wherein the netting constraints are selected from the group consistingof limits of trades; limits of notionals and combinations thereof. 21.The transaction hub according to claim 13, wherein the additionalnetting parameters include netting objectives.
 22. The transaction hubaccording to claim 21, wherein the netting objectives are selected fromthe group consisting of total gross notionals; number of trades;variance of the notional and combinations thereof.
 23. The transactionhub according to claim 10, further including an input of additionalalgorithm parameters.
 24. The transaction hub according to claim 23,wherein the additional algorithm parameters include a notional changeselector.
 25. The transaction hub according to claim 23, wherein theadditional algorithm parameters include a party search order.